Major stock averages post gains as strong jobs report trumps trade war fears

People who succeed in the stock market also accept periodic losses, setbacks and unexpected occurrences. Calamitous drops do not scare them out of the game. – Peter Lynch

In a holiday-shortened week, all three major stock averages rebounded with the technology-laden Nasdaq Composite Index turning in the best performance with a gain of over 2%. The Dow Jones Industrial Average, which is more influenced by global trade uncertainty since its constituents derive a significant amount of business overseas, rose less than 1%. For the better part of the week, the stock market was being held hostage by global trade tensions and trade war fears. On Friday, tariffs became a reality as U.S. tariffs on $34 billion of Chinese imports went into effect and China returned the favor by imposing a like amount on our farm products. The impact on the U.S. economy will not be felt immediately but the fear is that economic growth could slow if President Trump carries out his threats of even larger tariffs. Because China imports far less from the U.S. than the U.S. imports from China, the U.S. might have the upper hand since China’s ability to retaliate may be limited. While the uncertainty over trade and tariffs seemed to preoccupy the market for most of the week, it was the June employment report that really got investors’ attention. The government’s report showed that 213,000 new jobs were added during the month, which was better than expected, and the job totals were also revised higher in April and May. Although the unemployment rate increased from 3.8% to 4.0%, it increased for the right reason as more people returned to the job market and the labor participation rate rose. If there was any disappointing news in the report, it was that average hourly earnings or wage growth was just 2.7% year-over-year, which was less than expected. Maybe this was a blessing in disguise as faster wage growth could raise inflation expectations and lead to higher interest rates and further tightening by the Federal Reserve.

Last Week

The ISM manufacturing index in June rose to over 60, which was better than expected, and indicates that the manufacturing sector is expanding at a healthy clip. Manufacturing accounts for 12% of the U.S. economy and any reading above 50 is considered expansionary. Construction spending increased slightly in May and was less than expected and April was revised sharply lower, raising concerns that second quarter growth forecasts could be affected.

The Federal Open Market Committee (FOMC) minutes from the June meeting showed that Fed officials are worried that letting the economy get too strong and having inflation run too high could lead to a “significant economic downturn”. For this reason, they believe that interest rates should continue to be raised gradually on a regular basis.

For the week, the Dow Jones Industrial Average rose 0.8% to close at 24,456 and the S&P 500 Index gained 1.6% to close at 2,759. The Nasdaq Composite Index jumped 2.4% to close at 7,688.

This Week

Inflation data will headline this week’s economic data as the producer price index (PPI), consumer price index (CPI) and import prices for June are all expected to show only modest increases. The preliminary University of Michigan sentiment index for July is forecast to be on a par with the June number as consumers remain optimistic about the prospects for jobs and the economy.

The second quarter earnings season begins this week and the most notable companies expected to report include JP Morgan Chase, Wells Fargo, Citigroup, PNC Financial Services, PepsiCo and Delta Airlines.

Portfolio Strategy

Last week it was the strong and near-perfect employment report that trumped trade worries and tariffs and allowed the market to finish on a high note. This week the focus will be on the inflation data and the start of the second quarter earnings season, led by the big banks. At the beginning of the year, it looked like all of the conditions were in place for the financials to have a banner year. The global economy was strong, U.S. corporate taxes had been cut, interest rates were rising, spreads between rates on short-term deposits and longer-term loans were widening and excess capital was available to fund dividend increases and stock buybacks. But financial stocks have been one of the poorer performing sectors this year and have underperformed the S&P 500 Index. Even though the Federal Reserve has raised interest rates twice this year and has forecast two more rate hikes in 2018, the 10-year Treasury yield has fallen and the yield curve has flattened. The difference between the 2-year and 10-year Treasuries is less than 30 basis points, suggesting that investors don’t think interest rates will rise much in the future. (A basis point is one hundredth of a percentage point). This development could affect bank earnings since banks profit more when interest rates on loans are higher than the rates that they pay on deposits. Inflation data this week might also offer clues about the future direction of interest rates. Wage growth in the June employment report was less than expected and both the CPI and PPI this week are forecast to show only modest increases in prices. If that is the case, then interest rates may remain at these levels and bank earnings may suffer as a result.